Over the years I have been asked this question on many occasions. The enquirer is looking for a number but the number depends on many factors. So the answer is to explore a range of principles that apply to these factors.
Let’s look at this for both from the “gross profit margin” and the “net profit margin” perspectives.
Gross profit margin
The first issue to explore is how vertically integrated the business is. From procurement through production/delivery through to sales & marketing. What activities is the business responsible for and how complex are these activities? The growth phase the business is going through is also a factor.
The more vertically integrated and the more complex the activities, the higher the gross profit margin that is needed. High growth targets will also require a higher gross profit margin.
The reasons these factors need to be considered include:
• The more vertically integrated the business is, the more resources will be required to manage the business
• The more complex the business processes are, the higher the business maintenance costs (overhead costs involved in maintaining the business as a going concern) will be
• The higher the focus is on development and growth, the more resources that will be needed to achieve the development and growth targets
It is not uncommon, particularly with start up or early stage businesses for gross profit margins to be insufficient to achieve profitable outcomes. This is justifiable principally on the basis that the business needs a stronger market presence to be profitable, it has a strategy for achieving that market presence and it has the capital to fund operations until it achieves that presence.
I have seen businesses achieve success at gross profit margins anywhere from 20% to 80% (and businesses that have been unsuccessful at these same levels). The critical point is that the business should review their target gross profit margin based on the factors described here.
Net profit margin
The principles covered in the gross profit section have a major impact on the net profit margin. However, the business should also review its overhead costs based on separating the activities into:
• Maintenance activities (maintaining the current level of business), and
• Growth and development activities (building a bigger business)
Businesses that are pursing development or high growth strategies will need to fund these activities. For these activities to be funded by the business it will need either:
• Significantly higher net profit margins (if the growth involves major capital investment), or
• Significantly higher gross profit margin (if the growth involves gearing up resources such as additions to the sales force)
Alternatively the owners of the business can inject more capital and be prepared for a period of reduced margins.
At 3S CFO Group we work with a range of businesses to provide planning and modelling support to ensure that strategic directions are well understood and appropriately resourced.
Colin Wright is the managing director of 3S CFO Group
3S CFO Group is a member of the Association of Virtual CFOs